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Smaller is More Robust

There are many challenges that come with a large portfolio. It is the goal of most pooled investment funds to grow as large as possible, for the profitability, but also for the theoretical economies of scale, ie. spreading the same expenses over a larger revenue base. In reality, however, I haven’t seen economies of scale in investment funds. Remaining small has advantages, which will be explored below.

What does “small” mean? In Canada, the pool of liquid common share investments is relatively small, as our market represents only about 4% of the capital markets worldwide (American markets are about 50%). Our companies are also small relative to multinationals based in other countries. What is considered a large pool of investments funds ($2 billion or more) in Canada would not be considered large elsewhere. Further, it would not be considered large in the bond market, given that the fixed income market is about 17 times the size of the equity markets. Real estate is a different matter entirely, since each market is essentially local.

When investing in stocks, remaining small has a number of advantages with regards to remaining robust. The first is the ability to be nimble. Let’s compare the opportunities that exist for investing $100,000 versus $100 million. The shares of most companies over $100 million in market cap are liquid enough that at least $100,000 worth of shares trade on a given day. A plan to invest $100,000 at a given price might take a couple days to complete, but can usually be done at a chosen price. An effort to invest $100 million will not only exclude companies that are smaller than that size (in practice, about 10 times that, or $1 billion), but will move the market for the shares of any company that doesn’t trade more than $100 million worth of shares in a day. When an opportunity arises for buying or a situation warrants selling shares, most investors will want to be able to act quickly. Having a small investment relative to the target allows an investor to remain nimble.

As noted above, a smaller pool of capital can be more flexible. A small pool can be split up just as many ways as a large one, but it can also be kept together in a small number of investments (20 or fewer). With a pool of $1 billion, it’s difficult to imagine splitting it between just 20 companies, unless they were the 20 largest in Canada (or internationally). A small pool can also invest effectively in small companies, whereas with a large pool, buying the “maximum”10% of a small company might represent less than 0.1% of holdings, having effectively no influence on investment performance. A small fund is more manageable than an extremely large fund.

A large pool of capital can hardly move unnoticed. The advantages of remaining unnoticed include avoiding moving the market, as mentioned above, avoiding groupthink, less likelihood of attracting the regulatory gaze and avoiding competition. Groupthink happens when people acting in the same arena communicate their ideas. Certain ideas seem to take on a life of their own, being repeated more than others. Whether or not they are right, or accurately reflect reality, they are accorded a certain respect based on the frequency they are repeated. For example, the idea of a “double dip” recession in the United States was repeated throughout 2010 by economists, investors, journalists and observers. Even though, in my mind, there is little indication that we will experience another recession like the one in 2008-2009 within the next year or two, the idea has been repeated so much that many investors seem to have afforded it far more weight than it deserves. Investing fads seem to start the same way. What are the best investments coming out of the 2008-2009 market crash? Economists (correctly) said the government should stimulate the economy by investing in infrastructure. They had a great story about aging infrastructure and recent underinvestment. Investment managers adopted the theme and new infrastructure-focused funds appeared. However, improbably, REITs were the best-performing assets over 2010 (so far). Whether an investor subscribes to groupthink or contributes to it by taking a very visible position that propogates, it leads to overconfidence in ideas that are unproven.

Regulation and competition are two forces that can fundamentally change the profitability of investment decisions. Hedge funds offer a good example of both. New and innovative hedge funds are often formed to exploit the investment strategy of smart and energetic managers. As an example, some managers look to exploit expected price anomalies such as those surrounding mergers and acquisitions. A hedge fund could profit by buying the shares of a takeover target and short selling the shares of the acquiror. However, now that the idea is known, especially when the frequency of M&A transaction falls, competition will reduce the profitability of the strategy. Regulators have also begun to look at the previously unregulated hedge funds, requiring them to submit to more oversight and more legal requirements. This increases the cost of doing business and also decreases the flexibility of the fund (for better or worse).

Most people probably have no trouble keeping their portfolio small enough to be manageable. It does imply that as the portfolio grows, investing strategies will be less and less able to invest in small or thinly-traded stocks. This can be mitigated somewhat by separating the portfolio into different accounts (registered, non-registered, his, hers, etc.). Besides investing in large cap stocks, investing in bonds provides access to high liquidity. Real estate is an investment that, while not being liquid, offers the ability to invest large sums of capital. Keeping each investment small as a percentage of the total value of the asset improves liquidity, avoids undue competition and may avoid unwarranted regulatory scrutiny.

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